Bitcoin may be mad, but not half so mad as the mainstream economy

The Deep End has followed the progress of Bitcoin for a while now, but for anyone unfamiliar with the wacky world of private currencies, here’s a quick introduction from Ashlee Vance in Bloomberg Businessweek:

“Bitcoin is the digital currency that thrills nerds, inspires libertarians, and incites the passions of economists who debate the value of money made from nothing but ones and zeroes. Devotees watch the fluctuations of Bitcoin’s price with a fanaticism typically reserved for college football scores. Alternative currency startups are being lavishly funded by venture capitalists while visionaries gush about the world-changing possibilities of money free from government control.”

Supporters and sceptics of Bitcoin are agreed that it represents a genuinely different way of operating a currency – they just disagree as to whether that means different as in ‘revolutionary’ or different as in ‘on a different planet.’

But in one key respect both sides are wrong. Rather than representing a new departure from the old order, there’s something awfully familiar about the Bitcoin story. Indeed, many of the apparently stranger aspects of the new currency can be seen as a parable for the failings of the mainstream economy.

In particular, the bizarre business of Bitcoin ‘mining’:

“As with an actual precious metal, Bitcoins are in limited supply—they must be ‘mined.’ Unlike with precious metals, this mining is done purely by computer. Miners set their machines to run a series of complex calculations that tally up and certify all the transactions of other Bitcoin holders around the world. If the miner’s computers complete these calculations and solve a complex mathematical puzzle before anyone else, he earns about 25 Bitcoins as payment. It’s a nice haul: With the price of each Bitcoin nosing up near $1,000, that’s $25,000 for 10 minutes or so of work.”

In turns out that there’s a good reason why ‘Nakamoto’ – Bitcoin’s mysterious inventor – devised such a complicated method for issuing the currency. By spreading out the certification of Bitcoin transactions over a global network of diverse users, it makes it extremely hard for governments, fraudsters or counterfeiters to control or subvert the system. Furthermore, by embedding the workings of the currency within a puzzle-solving computational process, only a limited number of Bitcoins can be created – thus ensuring scarcity:

“Nakamoto’s puzzles are designed to get more difficult over time, solving them requires ever-escalating computing capacity. It’s an ingenious trick, like a Rubik’s cube that gets more complicated as more people try to solve it

“By 2010 the puzzles grew too difficult for ordinary desktops. Miners needed souped-up systems with fast graphics processors, typically used for playing high-performance video games or conducting intense scientific research, or they needed to distribute the problem among dozens of computers at once.”

With dizzying ups and downs, Bitcoins continue to appreciate in value – but not as fast as the increase in the processing power required to create them. This has led some observers to question the whole system:

“‘[Bitcoin] mining was supposed to be a democratized thing, but it’s now only accessible to the elite of the elites,’ says Chris Larsen, CEO of Ripple Labs, which has introduced a virtual currency called Ripple. It’s similar to Bitcoin but without the mining. (The company gradually hands out increments of the currency to supporters.) ‘Hordes of brilliant engineers are raising money for mining equipment that regular folks can’t compete with,’ Larsen says.”

It does indeed seem ridiculous – all of that computing power, all of that expertise, devoted to a task that actually requires very few resources at all: the creation of money. But before you dismiss Bitcoin as bonkers, you might like to have a think about how conventional currencies – the Dollar, the Euro, the Pound – are created and released into the economy.

If you haven’t worked it out, the equivalent of Bitcoin mining in the mainstream economy is the banking system – I’ll leave it to you to decide which involves the bigger waste of resources.